Monday, April 4, 2016

How many individual stocks do I need to consider myself diversified?

As an investor, I have always believed in diversification. I would rather err on the side of caution, rather than swing for the fences. It makes no sense to take excessive risks on a concentrated portfolio of stocks, particularly once you are financially independent or very close to it. In my case, diversification means not only owning a lot of individual dividend paying stocks, but also holding some fixed income such as government bonds and certificates of deposit that are insured.

As I have been talking about my plan, I often hear someone who tells me that I am not diversified. This statement is surprising, because my dividend portfolio includes something like 100 individual names. The 60 largest components account for most of the portfolio however. Someone always comes and tells me that I need to own thousands of individual stocks, in order to consider myself diversified. I disagree with that statement. I do not really have to look far, in order to refute this statement with actual data.

For example, I looked at the total performance of three stock market indexes over the past few decades from Morningstar.
Dow Jones Industrials Average an index consisting of 30 blue chip stocks, weighted by price. The Dow Jones Industrials average is the oldest stock market index in the world. It was started in 1896, and initially included 12 securities. Since 1928, editors at Wall Street Journal have put 30 leading blue chip companies in the index, which are representative of the US economy. You heard that right – the companies in this index are actively selected from a group of editors. The companies are weighted based on stock price. The ETF used in the comparison is Dow Diamonds (DIA).

S&P 500 (VFINX, SPY) – an index consisting of 500 blue chip stocks, weighted by free float and market capitalization. The S&P 500 index includes the shares of 500 companies that are mostly based in the US. The index was started in 1957, and is considered the most important benchmark when evaluating investment performance. The companies in the index are selected from a committee within Standard & Poor’s. The stocks are weighted based on market capitalization and free float.

Vanguard Total Stock Market Index (VTI/VTSAX) – an index consisting of roughly 4,000 US stocks, weighted by free float and market capitalization. The number of companies varies – I believe it was much higher in the late 1990s.

I looked at total returns since April 27, 1992, through March 20, 2016. Each of those three portfolios had roughly similar returns, while Dow Jones Industrials Average managed to slightly beat them all. This was mostly due to the fact that crappy technology companies were underrepresented during the 2000 – 2002 bear market in the Dow Averages, while S&P 500 and Vanguard Total Stock Market Index had an above average allocation to overvalued technology companies.

The funny part is that the returns on all three groups of stocks are roughly similar over time. The 10 largest components of S&P 500 account for 17.62% of the index, while the 10 largest components of Vanguard Total Stock Market Index account for 14.37% of the index. Based on my research, the 500 or so companies in the S&P 500 account for something like 80% of the Vanguard Total Stock Market Index. As you can see, most of the 3000+ components of Vanguard Total Stock Market Index are mostly filler to make you feel better about being diversified. The lowest 3000 individual components are unlikely to really added much, because their weights are comically low.

I have looked at different portfolios, and I can tell you that as long as you have a portfolio consisting of at least 30 - 40 companies that are representative of as many sectors as possible, there is a very high likelihood that you would earn a total return that is very close to that of investing in say the S&P 500. My historical review of the Corporate Leaders Trust, which was founded in the 1930s discovered that a portfolio of 35 stocks with super low turnover could do not only as well as the S&P 500, but also slightly beat it over time.

To be honest, the real reason why indexing does well over time is due to:

1) Low costs to hold stocks since no analysis is done, no expensive portfolio managers are hired for research etc
2) Low turnover which reduces impact of taxes, transactions and selling potential big winners
3) Provides a group of stocks to buy to investors who lack the discipline or knowledge to create own portfolio of individual stocks
4) The investor sticks to their strategy through thick or thin, and makes money when the improving global economy increases earnings, dividends and share prices

As a dividend investor, I try to build a portfolio of companies from as many industries that make sense. I have a quality filter, in order to reduce the likelihood of including a fly-by-night operator in my index that gets a high weight because others are foolishly bidding up the price ( Nortel, Valeant, Worldcom anyone?).

After a stock pass through my screens, and after making sure that I am not overpaying, I essentially have a representative portfolio of as many of the major sectors that make sense. I then:

1) Have low or no costs because I simply hold on to my diversified group of stocks
2) I have low turnover, because I only sell when I get a dividend cut
3) If I get lazy, I can afford to do nothing as long as dividends are not cut. PepsiCo (PEP) will keep baking its chips, coming up with new products, running its operations, hiring/firing employees no matter whether I read their annual report or not. As long as they keep maintaining the dividend I will keep holding the stock.
4) I stick to my strategy through thick or thin, and let the future expected growth in the economy lift earnings, dividends, and business values

I also do not get the point as to why it is preferable to blindly purchase a list of 30 – 500 – 3900 securities, but it is risky to individually select 30 – 60 – 90 individual securities, maintain weights, avoid purchasing expensive securities etc. I would think that if all else is equal, the focus on initial valuation would improve the odds of generating a decent return and reduce my odds of loading up on risky companies with unproven business models that everyone is salivating about. This is why Dow Jones Industrials Average did better than S&P 500 in 2000 – 2002.

As I have said hundreds of times on this site, I am mostly focused on building out a sustainable stream of dividend income for retirement. I am choosing to focus on dividends, because they are more sustainable than capital gains. The amount and timing of dividends is easier to predict and live off, than the amount and timing of capital gains. Therefore, it makes perfect sense to focus on dividend income, and ignore the crazy stock price fluctuations, knowing that at the end of the day I am working towards reaching my own goals. And I believe that I do not need to own 3,000 - 4,000 individual stocks in order to be diversified.

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